Russian Federation - 2006 Article IV Consultation, Preliminary Conclusions of the IMF Mission
June 26, 2006
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
I. Near Term Prospects and Policy Challenges
1. Real GDP growth is gaining momentum, becoming better balanced but running close to potential. Growth has mostly recovered from the 2004-2005 slowdown as domestic demand has accelerated, propelled by further large terms-of-trade gains and a fiscal easing that entails saving less of such gains. The recovery in demand has been led by investments. While potential GDP growth in the mission's assessment has edged up to 6-6½ percent per year, resource constraints are tightening in both products and labor markets as domestic demand continues to significantly outpace potential GDP growth, causing increasing leakage through imports. Exports are also hampered by emerging capacity constraints and contribute now little to growth, following a precipitous slowdown in oil extraction in 2004-05. Looking forward, the large terms-of-trade gains already in store and the fiscal relaxation entailed by the 2006 budget mean that domestic demand is set to continue to grow significantly faster than potential GDP during the remainder of 2006 and going into 2007. We expect real GDP growth to amount to 6½ percent in 2006 and to remain at or above potential in 2007.
2. Fiscal relaxation is adding to demand pressures. While the headline surplus of the government has increased as oil revenues have continued to rise, fiscal policy has been relaxed notably during the past 12-15 months inasmuch as the government has been spending much more of its oil revenues. Thus, the amended 2005 budget and the 2006 budget entail an increase in the non-oil primary deficit of the federal government of 2¼ percent of GDP between 2004 and 2006. At the level of the general government, the increase amounts to as much as 3½ percent of GDP. This relaxation has significantly exacerbated the already strong cyclical pressures and has been a main reason for accelerated appreciation of the ruble in both nominal and real terms.
3. Against this backdrop, we are concerned about plans for further fiscal relaxation. The possibility of an amendment to the 2006 budget and the preliminary plans for 2007 discussed with the mission suggest a further increase in the non-oil primary deficit of up to 1 percent of GDP. Considering the buoyant outlook for domestic demand and the tightening resource constraints, such an increase is in our view excessive as it will accelerate the pace of real ruble appreciation and test the CBR's resolve to maintain inflation on a downward path. In coming to this judgment, we recognize that the government is seeking to strike a balance between cyclical considerations and the wish to use oil revenues to finance much needed reforms and investments. In this regard, we understand that the selective wage increases in the public sector are intended to pave the way for reforms, but are concerned about the effectiveness of this approach at a time when comprehensive public sector reforms appear to be on hold. More generally, the rise in non-interest expenditure of 1¼ percent of GDP contemplated in 2007 is in our view not sufficiently targeted on reforms that promise to have an early and strong impact on potential growth to justify the attendant inflationary risks. We believe that fiscal policy should give more weight to containing demand pressures at this time, suggesting that the relaxation in terms of the non-oil deficit should be limited to no more than ½ percent of GDP. Considering that the execution of the 2006 budget is already considerably backloaded, we also suggest to forgo an amendment to the 2006 budget, in order to minimize additional fiscal stimulus at a time when demand pressures associated with the sharp rise in the terms of trade remain strong. The mission welcomes the recent agreement to pre-pay all of Russia's outstanding Paris Club debt.
4. The increased exchange rate flexibility is welcome. Even as demand pressures have increased and resource constraints tightened, the CBR has succeeded in setting inflation on a renewed downward path, following 2-3 years of entrenched inflation. While this has partly been due to one-off factors, such as slower increases in administered prices, it owes much to the notable nominal effective appreciation of the ruble since the beginning of 2005, in contrast to the steady depreciation until then. Developments during this period provide a reminder of the CBR's vanishing scope for affecting lasting changes in the real exchange rate as idle resources in the economy are being soaked up; the choices now available to the CBR are whether to let the real appreciation that is inevitably associated with the strong demand pressures take place through nominal appreciation or through inflation. Criticism that the CBR's exchange rate policy is spurring real appreciation and threatening economic growth is thus misplaced. On the contrary, by focusing on inflation reduction, monetary and exchange rate policies are now better geared towards achieving the lasting reduction in real interest rates and deepening of financial intermediation needed to sustain high growth over the medium term.
5. The inflation target is within reach. With continued exchange rate flexibility, we believe that the end-year inflation target of 8½ percent is achievable, as is the further reduction to 6½ percent next year, the lower end of the target range for 2007. To help anchor inflationary expectations, the CBR should in our view commit more openly to keeping monetary policy firmly focused on inflation control and should refrain from stipulating even indicative nominal and real exchange rate targets. Moreover, while formal inflation targeting is premature, we believe that the CBR could already now move to strengthen its monetary policy framework by focusing on an inflation path rather than an end-year target, and on a measure of core inflation that is unaffected by seasonal variations.
II. Medium Term Issues
6. There are tensions between short- and medium-term fiscal objectives. Considerable scope exists for fiscal relaxation over the medium term as even conservative forecasts suggest that oil prices will remain well above the current cut-off price for the stabilization fund of $27 per barrel. Once cyclical pressures ease, such a relaxation is indeed desirable considering the pressing need to raise the level of investments, as well as that of reducing global imbalances. The challenge in this regard is to harness Russia's oil wealth in support of reforms and investments that will boost potential GDP growth over the medium term. The risk is that oil revenues are wasted on a gradual increase in expenditures and on tax cuts that will not raise potential growth, causing the real exchange rate to overshoot its long-term equilibrium and raising the non-oil deficit to levels that can not be sustained once oil prices retreat from historical highs. The steadily increasing non-oil deficit, in combination with the slowness of reforms in recent years, underscores the seriousness of this risk. To help reconcile this inherent tension the mission welcomes proposals to buttress the fiscal policy framework, in particular to frame targets in terms of the non-oil balance and to move to rolling three-year federal budgets with a detailed breakdown of revenue projections and expenditure appropriations.
7. We are concerned that the current high levels of growth cannot be sustained without an acceleration in structural reforms. Analysis suggests that potential output growth is largely driven by productivity gains, with only small contributions from capital and labor, notwithstanding the recent acceleration in investment. These gains reflect the catch-up potential at this stage of economic development, where enterprises have significant scope for upgrading equipment and technologies while labor and capital are reallocating to faster growing sectors. While the mission agrees that there is considerable potential for further unleashing such productivity gains going forward, it is concerned that this cannot continue to be achieved on the scale of recent years, even in an environment with continued high oil prices, without a more determined push for reforms. The fact that Russia's GDP growth is among the lowest in the CIS, despite the strong terms of trade gains, is a reminder of underlying vulnerabilities. We believe that addressing these vulnerabilities by accelerating reforms, while high oil prices are still boosting the economy, should be a matter of priority.
8. In view of this, we are concerned about the uneven progress in implementing structural reforms. In several important areas, technical preparations have advanced and the legislative and institutional framework have been strengthened. However, actual implementation appears to be somewhat slow, not least by comparison to the goals for public sector reforms that the government set for itself upon assuming office. Looking ahead, with a view to focusing on reforms that have the promise to quickly increase productivity growth, we believe that priority should be given to reforms of natural monopolies and other sectors where the state effectively remains in control, as well as to administrative and civil service reforms. We, therefore, welcome the decision to speed up the long-delayed reform of the electricity sector, including through increased support from the budget. On the other hand, the increased state ownership in the oil and gas sector raises in our view questions regarding the future dynamism of this sector, which has been a main source of growth until last year. Concerns in this regard are illustrated by the way in which private oil companies took advantage of the steady increase in energy prices from 1999 to increase investments, achieving a sharp reversal of the decade-long contraction in output, a development that stand in stark contrast to the virtual stagnation in the state-controlled gas sector during the same period.
9. Several important changes affecting competition and the business climate are under consideration. We welcome proposals to push ahead with changes to the law on the tax administration aimed at, among other objectives, improving transparency. We also support the changes in taxation of the oil sector in light of the apparent capacity constraints in this sector, but the authorities must be alert to any compliance problems that may arise from the added complexity, including differentiated tax rates. We also note that investors are unsettled by uncertainty about the government's plans regarding the subsoil law and the law on strategic sectors, and believe that an early clarification is needed. Finally, early an conclusion of WTO negotiations could help catalyze reforms and bolster the investment climate.
III. Financial sector issues
10. The banking sector has continued to expand rapidly benefiting substantially from the good macroeconomic environment, but risks are building up. Banking sector profitability remains strong and aggregate financial soundness indicators seem benign. However, several vulnerabilities have emerged. Loans to households, especially consumer loans, doubled in 2005 and the share of past due loans for household credits has increased significantly. A number of banks have relaxed lending standards for mortgage loans and credit concentration on major borrowers is still high. The recent expansion has also strained banks' liquidity and capital ratios, while market risks have grown along with increasing exposures of banks to equity and fixed-income securities.
11. Progress has been made in strengthening banking sector supervision. The CBR has tightened its supervision of banks and continues to revoke banking licenses, mostly on grounds of violations in anti-money laundering regulations. The increase in the minimum capital requirement is also expected to support banking sector consolidation. The mission welcomes the authorities' efforts to weed out weak banks and to improve the framework for mergers and acquisitions in the banking sector.
12. Generally, the mission believes there is a need to further strengthen supervision and accelerate the pace of reforms in the banking sector. Priority should be given to supervising banks on a consolidated basis, thoroughly assessing internal credit-risk models, and ensuring that banks maintain adequate capital levels to cover direct and indirect risks in their portfolios. The legal and regulatory basis for bank supervision should also continue to be strengthened, particularly by reinforcing the powers of the financial regulator to intervene preemptively in problems banks. Other areas where progress has been slow include: (i) widening the definition of connected parties; (ii) reinforcing the powers of financial supervisors to conduct fit-and-proper tests for owners and top managers; (iii) improving governance and the transparency of bank ownership, (iv) strengthening non-bank financial sector supervision, and (iv) adopting International Financial Reporting Standards. The mission also believes that higher priority should be given to the development of a strategy and timebounded action plan for the future of state-owned banks. A Financial Sector Assessment Program Update mission scheduled for later this year will provide a timely opportunity for an in-depth review of financial sector vulnerabilities.
13. The CBR is concerned that it could be unable to meet the liquidity needs of the banking system in the future. With liquidity injections almost entirely resulting from foreign exchange interventions in recent years, it wants to be ready, in case the current account surplus wanes, to provide credit through its domestic window by expanding the range of collateral to include high-rated corporate paper. However, such a change is, in our view, unlikely to be necessary soon as the gradual reduction in the current account surplus could very likely be offset by additional inflows of capital over the medium term as structural reforms take hold. In this regard, we welcome the recent initiative to liberalize the remaining capital account restrictions. Moreover, strengthening of supervision and consolidation and reforms in the banking system will bolster the confidence needed to spur continued domestic financial intermediation, suggesting that funding does not need to come from the CBR. In any case, considering the governance and risk assessment problems in the banking system, we would urge the CBR to exercise great caution in refinancing through use of corporate collateral.